Return on capital employed (ROCE) determines how much entity has earned for each dollar of all the different types of capital it has employed i.e. equity, long term borrowings, short term borrowings etc.
ROCE can be calculated using the following ratio:
|Return on Capital Employed (ROCE) =||Return|
The term return and capital employed are very generic in nature and how they are defined depends on the information available for analysis, requirement of the user of information and circumstances surrounding the decision.
Return can be either of the following:
- Operating profits
- Profits before interest or Profits before interest and tax [PBIT]
- Profit after tax
- Profits available for ordinary shareholders
Same way capital employed can be any of the following:
- Equity and long term borrowings
- Equity and Long + Short term borrowings
- Equity – preference shares
- Weighted average ordinary shares
Important point to understand is that such amount of returns to be considered that are relevant to capital under assessment i.e. matching like with like. For example if user is interested in knowing the ROCE for both equity and long term borrowings then relevant returns can be operating profits or profits before interest.
Similarly if user is interested in ROCE for ordinary shares then relevant returns are only those profits that are available for distribution to ordinary shareholders. This is usually calculated as:
|Profit after tax for the year||###|
|Add: Opening retained earnings||###|
|Less: Preference dividend||(###)|
|Earnings available to ordinary shareholders||###|
Having correct numerator and denominator figures will help better understand the returns particular investment is making and to assess if its enough for the risks of such investment.
Another confusion can be which capital should be use for analysis purposes? Should it be the capital employed by the end of the period? Should it be the capital employed at the start of the period? For this reason some analysts suggest to use average capital employed. Average is taken as following:
|Average capital employed =||Opening capital + Closing capital|
Analysis and Interpretation
ROCE determines profitability of the business. Shareholders and prospective investors are interested in entity’s ROCE as they want to know if entity’s returns are high enough to cover its cost of capital.
Cost of capital includes interest on long term borrowings, dividends on shares etc. Ideally entity should make enough profits that not only cover business expenses but also these “costs” and still have profits to retain. In short, higher the ROCE the better.
Looking at the ratio, mathematically entity’s ROCE will improve if:
- numerator i.e. return increases; and/or
- denominator i.e. capital employed decreases.
Increasing the return require increase in revenue or decreasing overall entity’s expenditure on cost of sales and other expenses so that operating profits and profit after tax increases. This is where entities start cutting down non-developmental expenditures like administrative expense. Usually this is the reason why research and development get frozen as ROCE is rescued with these strategies.
Decreasing capital employed, though can help improving ROCE, is not always a probable solution but this is definitely an option under dire circumstances. Entities can buy back shares, payout their long term term debts to reduce the capital employed figure and ultimately improving ROCE.
Paying off non-current liabilities is probably the best strategy in this case it not only reduces the reduces the capital employed but also improves entity’s debt-equity ratio thus reducing financial risk. Another significant benefit can be savings interest cost savings as entity’s profit won’t be burdened with borrowing costs and thus improving profit figures.
But high ROCE doesn’t always mean good enough ROCE. ROCE is not an isolated metric. It is very closely knitted with risk entity is facing. It may be the case that another entity with similar amount of profits and similar amount of capital employed is considered safer for investment. In this case, investors will ask for higher return thus increasing cost of capital and potentially locking up entity from taking borrowing more money.
So you can see ROCE alone is not important but judged in context of risk i.e. if entity is providing good enough return considering business risks and if existing investors should keep their money with entity or withdraw their investment.